The Comprehensive Family Trust Fund Guide

If you are thinking about setting up a trust fund for loved ones in your family, and would like a basic overview of the process and issues to think about, I have prepared a comprehensive guide of what I consider to be the main issues associated with establishing a trust fund.

The mechanical reality of a trust fund is far more mundane than that—it merely refers to any instance in which the control of an asset is separated via a contract between the person who benefits from an asset and the person who now controls the management of the asset. A second requirement is that you must intend to create a trust when you splice up benefit and control. Technically, a third requirement is that the person managing the money must agree to manage the trust.

If you look to your bank account, see $250,000 sitting there, and write a check for 2,380 shares of Anheuser-Busch (BUD) stock, you are merely holding the investment in your individual name.

You have full control over the asset—you can reinvest the dividends, you can take the dividends as cash, you can invest the dividends into something else, you can sell some of the stock, you can sell all of the stock. And then, whatever decision you make, all the proceeds go to you. There is a complete unity between control and benefit—the same person who is making the buy and sell decisions for the asset is the same person that ends up receiving any profit or loss from the decision.

On the other hand, if you go down to the bank and hand them $250,000 in cash or those 2,380 shares of Anheuser-Busch, and indicate that you want to create a trust and the bank accepts, you have now created a trust fund. The distinguishing characteristic is that the person controlling the asset (the bank management team) is now separate from the person who is benefitting from those decisions (whoever you name as the beneficiary).

At that point, you have given up ownership of the asset. It is no longer yours, but belongs to the trust (in filing documents, those 2,380 shares of Anheuser-Busch would be owned by the trust). The bank gets to make the buy and sell decisions for the stock and any other assets that end up in the trust, subject to limiting instructions in the written agreement that you use to set up the trust. The incentive for the bank to do this is that they get to collect a fee. Meanwhile, the beneficiaries get to receive the proceeds that flow from the decision. This is why someone would agree to create a trust fund by giving up direct ownership in the first place—they cede management control but they get to choose who benefits from all of the value created.

For instance, you may have seen the statistics that show the average trust fund contains over $4 million in wealth. That data is heavily skewed by the Forbes 400 types who create trust funds worth hundreds of millions or even billions of dollars. These outliers certainly skew our perception of the data. After all, if you grabbed two people from the local soup kitchen and stuck them in a Dairy Queen restaurant with Warren Buffett, you could claim that the average wealth of each Dairy Queen patron was $30 billion. To avoid the distortive effect of outliers, it is much better to look at median data points. The median trust fund figure is a wealth transfer of $285,000. This statistic points out that much of the rhetoric surrounding trust funds is filled with mythology—the reality is that hard-working Americans that save up a few hundred thousand dollars over the course of their life are the typical creators of family trust funds now.

What Exactly Are The Fees Associated With Managing A Family’s Trust Fund?

It depends. If it brings you any consolation, it causes me as much annoyance to give a wishy-washy answer as it probably annoys you to read it. But there are so many variables relating to size, the types of investments within the trust, the complexity of the instructions, and just plain old differences based on competencies of the trustees that make it difficult to speak with any specificity about the costs of setting up a trust fund.

Generally though, the rules for trust funds that only contain cash, stocks, bonds, and real estate investment trusts with relatively simple instructions has a fee breakdown as follows:

An annual trustee management fee of $2,500 to $5,000, regardless of the size of the estate.

A $600 fee for preparation of the tax returns for the family trust fund.

And usually, there is a staggered fee for the management of assets that goes something like this: you pay a 1.5% annual management fee for the first $500,000 in assets, then 1.15% on the next $500,000, and then 0.75% on any amount over that.

That annual trustee management fee mentioned above is why it does take a decent accumulation of capital for a trust fund option to be worthwhile. If you have $100,000 to put in a trust fund, a $5,000 annual fee would eat up half of your starting capital within a decade. You need to reach a point where that initial $5,600 annual fee (counting tax preparation) does not eat up such a meaningful chunk of capital.

Personally, I was surprised that the median figure for a trust fund was $285,000. Counting a possible $5,600 plus a 1.5% fee that takes out another $4,275, we are talking about $9,875 in fees on a $285,000 principal amount for a total cost of 3.4%. That strikes me as absurdly high, considering that these fees do not include trading fees from the purchase and sale of trust investments nor do they include any tax obligations.

On a $250,000 trust, you could be spending 5% per year just in comprehensive transaction costs. Considering the average trust fund only generates 5-6% per year, you can see the problem—nearly all of the gains are going to the management of the trust (this may be tolerable if you are setting up a trust fund for a beneficiary that you know poses a risk of burning through all of their money if left to their own devices so the high fees might be tolerated for the steady hand of a bank’s trust department that protects your child or other chosen beneficiary from a worse scenario).

The most common question, then, is this: What is the bare minimum amount of capital that you can set aside to create a trust fund that makes the gains greater than the tradeoffs? There are a lot of variables, but I would say somewhere around $500,000-$600,000. That can get your management costs down below 2%, and gives your capital a chance of compounding while reaping the other benefits of the trust structure. When you only talk about a hundred thousand or two in capital, the protections afforded by the trust are probably offset by a fee structure that makes the trust fund your enemy by assuming nearly all of the wealth that the trust principal would create.

What Are The Benefits Gained By Holding An Asset In Trust?

First, trust funds can serve as the means to lower the value of your estate that may be subject to estate taxes by permitting you to take advantage of the gift tax exclusion in trusts. This is especially attractive if you pool all of your assets into a holding company that is owned by the trust, so you and your spouse can transfer $28,000 of ownership to your children as beneficiaries per year without any tax consequences. This tax-free wealth transfers lower the valuable of your gross estate that will be subject to the estate tax at your time of death, and you can include a written instruction in the instrument that sets up the trust fund which says each beneficiary shall receive a transfer of a number of shares that equals the annual gift tax exclusion during the first week of each year.

Secondly, trust funds enable you to plan ahead for your death by including written instructions that will carry out your desires for the funds that you put into the trust. When you are alive, if you intend to give your kids $10,000 per year at Christmastime, you can easily carry that out. What if you want that to continue happening after you die? Well, you are permitted to include a provision in the trust instrument that says “On the final business day before Christmas each year, each beneficiary shall receive a disbursement of $10,000.” Because trusts are perpetual in duration unless the trust instrument contains a termination provision or state law calls for the dissolution of the trust fund, these disbursements are not affected by your death.

Third, by putting your assets in trust, they are not part of your probate estate because those are not your assets to be settled at death (remember, the trust itself is the owner of the assets). Avoiding the probate process lets you dodge the thousands of dollars in fees that would be charged by the probate court, you can avoid the twelve to eighteen month long delays that your beneficiaries would have to wait before receiving an inheritance. With a trust, the disbursements continue seamlessly. Also, the disposition of an estate is a public process, and so if you want to avoid having nosy people voyeuristically observe the administration of your estate, a family trust fund can be a great tool to create privacy for your assets.

Fourth, the trust fund can be structured so that any divorcing spouse of your beneficiary, creditor, or tort claimant will be prevented from reaching the assets of the trust (although some states now permit DIU victims to go after trust fund beneficiaries on the theory that the injustice of not allowing a DIU victim to collect is worse than the injustice of frustrating the intentions of the creator of the trust fund). The reason why the beneficiary is able to dodge these types of liabilities is because each investment is owned by the trust. The trust itself can’t commit torts or get divorced, and therefore, its assets cannot be seized because the beneficiary does not own the assets—he only receives what it produces.

Who Is Involved In Setting Up A Trust Fund?

At a minimum, you need three people involved to create a traditional trust fund. You need the person who is going to commit the money and assets that will be included in the trust, you need the person who is going to receive disbursements from the trust, and you need someone who manages it.

The person who puts assets into a trust fund and creates the written instructions for how the trust will be managed and who will receive the funds is called the “settlor.” Often times, people think that a settlor just contributes the money and goes away. That may happen, but it does not have to be so. A settlor is entitled to retain some limited authority for himself—for instance, he could write into the agreement that a giant block of Johnson & Johnson stock cannot be sold and he the settlor shall receive the dividends from it until he dies and then all future dividend checks go to his wife or kids that he names as the beneficiary. Also, contributions to a trust fund do not have to be a one-time thing. A settlor can put $1,000,000 into a trust fund this year, and then add another $250,000 to it the next year.

Second, there are the “trustees” who manage the trust. Basically, they are the highest executive agents of the trust and have control over which investments get made. They also have control over the disbursement. This can be a frequent area of conflict if there are immediate trust beneficiaries and something called remainderman (people who become beneficiaries after someone dies, such as a grandchild). The reason it becomes such a conflict is that the trustee owes an equal duty to the current beneficiaries as he owes to the remainderman beneficiaries.

This is why you see beneficiaries say things like “The trustee is keeping me away from my money.” It is because the trustee is limiting disbursement to a current beneficiary to also make sure that there is something leftover for the next in line. This conflict can be avoided by including written instructions in the trust agreement about how the trustee must manage the funds (say, give $25,000 to each beneficiary each year) which is up to the settlor at the time of creation. Otherwise, the trustee has enormous discretion to act in the best interests of the trust, and that may mean that the beneficiary receives much lower payouts than is initially imagined.

Third, you have the beneficiaries, which just refers to the people who passively receive disbursements from the trust. They have no, or very little power, over what assets the trust fund contains or when buy and sell decisions are made. The settlor has the initial right to set the terms, and any right that he does not retain or spell out is instead subject to the discretion of the trustee (which is usually a member of the trust department at a local or large bank).

And fourth, sometimes you will see trust funds have an “appointer.” This is an exclusive power to fire trustees or add new trustees to the trust fund. Frequently, you will see the settlor make himself the appointer. The advantage of this power is that the settlor can create a trust fund in his lifetime, see if he likes how the trustees manage the fund, and then retain for himself the power to fire the trustees and replace them with somebody else if he doesn’t like them (if he doesn’t retain the appointer power for himself, then it will require a court order to fire a trustee and the threshold for doing so is high because you have to show cause).

What Conflict Of Interest May Exist For The Trustee?

Like everybody else, trustees enjoy have a wide degree of autonomy and power. This often includes a desire to make low payouts to beneficiaries because it is in their interest for the trust fund to last forever and they collect fees that are a percentage of assets. Put another way, once a trustee makes a $50,000 distribution, that money is gone forever and the bank managing the trust fund is no longer earning any money it.

Often times, you will receive cautionary advice about how the trust fund may run out of capital, and so the trust fund disbursement should be kept low so that the funds do not run out. This advice is often sound, but can be overdone.

Trust funds are fee machines for banks, and there is an incentive to protect this holy cash cow at all costs. Trustees will often talk to you about needed flexibility because you never know what might happen next, and they may encourage you to draft a trust agreement that gives them wide discretion.

No. When you’re transferring your assets into a trust, it’s still yours to decide how it is used. Figure out ahead of time exactly what you want the money to do and why. And then include instructions to that effect. The last thing you want is to save up a million dollars and think that you are setting your kids up for $40,000 per year for life and then they only receive disbursements of $15,000 while the trust value balloons upward. Money is a tool that exists to serve us and not be built up endlessly for its own sake, and you should pay heed to this risk before crafting your trust instrument.

You can also mitigate this risk by reserving appointer powers for yourself and someone else you trust to be your successor appointer after you die so the trustees can be fired if they are not carrying out your wishes. Ideally, the successor appointer should be someone that is independent of the beneficiaries so they don’t arbitrarily fire a trustee who does act with restraint and prudence when it is warranted.

How Can You Tell If The Trustee Is Managing The Trust Properly?

There are at five things I would look for to determine whether the trustee is doing a good job of administering the trust. Ideally, this evaluation should occur while a settlor is still alive and has reserve appointer powers for himself so the evaluation can result in the firing of the trustee if his service proves inadequate.

Second, you should be wary of a trust fund that is loaded with expensive mutual funds inside of it. There is a terrible, though not illegal, practice of trust management teams receiving revenue sharing agreements with mutual fund providers that charge a 1% or higher expense ratio for funds held in the trust. This means almost double fees: the trustee gets the 1.5% for managing the trust, the funds themselves are invested in mutual funds that charge 1%, and all of a sudden, the fund has turned into an obscene fee-eating machine that is difficult to detect if you are not trained to be skeptical of a trust fund stuffed with mutual fund holdings.

Third, you should monitor the financial statement and see whether the specific transactions of the trust seem necessary and are in accordance with the stated instructions mentioned by the trustee during your meetings with him. If the trustee talks about stodgy capital preservation but the fund is loading up on biotechnology stocks with no current profits, there is an incongruity between the stated goal and the means of achieving it.

Conclusions About Setting Up A Trust Fund

A family trust fund can be an absolute dream scenario for those trying to create financial security for those whom they love. At its best, it combines financial expertise with large growing distributions that are efficiently executed on a regular, periodic basis and provide enhanced legal protection against your beneficiary’s legal claimants. However, there are obstacles to setting up a successful trust fund. Namely, there are high fees, potential for conflicts of interest, and the possibility for your intention to be thwarted if the initial instructions in the trust instrument are vague. Successful estate planning requires months of philosophical thinking and a deliberate search for the right trustee, but the resources committed to getting it right are worth the effort in the end.

Disclaimer

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